# Demonetisation: Can Indian Banks Handle Low Interest Rates?

Dec 16, 2016

One of the benefits of demonetisation that is being bandied around is lower interest rates. Suddenly, banks are flush with a huge amount of deposits. The demonetised Rs 500 and Rs 1,000 notes need to be handed over to banks as well as post offices by December 30, 2016. The total value of demonetised currency is Rs 15.44 lakh crore.

Between November 10, 2016 and December 10, 2016, Rs 12.44 lakh crore has made it back to the banks. Banks have issued new notes as well as notes which continue to be legal tender of Rs 4.61 lakh crore to the public over their counters and through their ATMs.

What this means that the deposits with the banks have gone up at a very rapid pace. Between November 11 and November 25, 2016, the aggregate deposits with banks went up by 4 per cent. This increase was within a span of just 15 days. (This is the latest figure that is available.)

Given this, huge and sudden jump in deposits, it is but natural that the banks will cut the interest rates that they offer on their deposits. At the same time, the overall lending by banks (non-food credit) during the 15-day period fell by 0.9 per cent.

Hence, a rise in deposits and a fall in loans will lead to banks cutting interest rates on their deposits and then on their loans. At lower interest rates both businesses as well as consumers will borrow and spend more. And this will help economic growth. Or so we are being now told.

This, as I have often argued in the past, is a very simplistic argument. (You can read one such argument here in the Letter that I write every Friday). Lower interest rates for borrowers are just one side of the equation. We also need to consider lower interest rates for savers, who form the other side of the equation. There can't be any borrowers without savers. Look at Table 1.

##### Table 1: Financial Saving of the Household Sector.

As can be seen from Table 1. Deposits form a bulk of the household financial savings. Between 2011-2012 and 2015-2016, the share of deposits in the household financial savings has come down. Nevertheless, it remains a major part of how people save. If interest rates on deposits come down, people need to save more to meet their savings goal. This means lesser consumption, which has an impact on economic growth. There is also a possibility of not saving enough and not meeting their savings goal, which again is not a good thing. This could mean not having an adequate amount of money for the education of children, among other things.

Further, in a country with very little social security, the senior citizens use fixed deposits to generate regular monthly income. A sudden fall in interest rates hurts them the most. This is another thing that needs to be kept in mind. Hence, fixed deposit interest rates at any point of time should be at least 150 to 200 basis points higher than the prevailing rate of inflation as measured by consumer price index. This is not a perfect formula, given that each one of us has our own rate of inflation, but then something is better than nothing.

Given that it is the largest borrower, it is understandable that the government keeps batting for lower interest rates. But lower interest rates are not necessarily good for everyone and mindlessly advocating lower interest rates as many experts and industrialists tend to do, is not good for anyone.

Take the case of banks. How responsibly can we expect them to lend? If we look at the recent record of the banks, they don't inspire enough confidence. In fact, this is precisely the point made by Pallavi Chavan and Leonardo Gambacorta in the RBI Working Paper titled Bank Lending and Loan Quality: The Case of India. The paper was published on the RBI website on December 14, 2016.

The major point that Chavan and Gambacorta make is as follows: "We find that a one-percentage point increase (decrease) in loan growth is associated with an increase (decrease) of NPLs over total advances (NPL ratio) by 4.3 per cent in the long run." What does this mean in simple English? It essentially means that for every one per cent increase in loans the bad loans ratio goes up by 4.3 per cent.

This basically means that when the times are good, Indian banks go easy on the lending and end up giving loans to even those who don't deserve a loan. As Chavan and Gambacorta point out: "Banks tend to take on more risks during an upturn in credit growth and be more cautious whenever there is a downturn."

So why do banks go overboard while lending while times are good? The simple reason is that when times are good there is far greater competition to lend and in this scenario, the lending conditions tend to get relaxed.

But there is another reason as well-crony capitalists. As Chavan and Gambacorta point out: "Well-capitalised banks tend to take on less credit risk". What does this mean? It means that banks which have more capital tend to take less risk when it comes to giving out loans. Hence, banks which have less capital tend to take more risk while giving out loans. The question is which banks have less capital? Public sector banks.

The new generation private sector banks, which form a bulk of the private sector banking in India, are much better capitalised than the public sector banks. So, what is it that leads to public sector banks going easy on the lending? While Chavan and Gambacorta don't say so, the answer perhaps lies in crony capitalism.

Politicians force public sector banks to lend to their businessman friends or crony capitalists. The projects are poorly financed with the businessmen putting very little of their own money at risk. As Raghuram Rajan said in a November 2014 speech: "The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit."

To conclude, those talking about lower interest rates leading to higher lending to businesses, should also keep this in mind. Public sector banks are not adept at lending, at least not as long as they remain public sector banks, which allows politicians in power to interfere.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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3 Responses to "Demonetisation: Can Indian Banks Handle Low Interest Rates?"

S K LIMAYE

Dec 16, 2016

The author has very rightly said that lower lending rates is only one side of the equation.The other side is lower borrowing rates means lower interest rates on FDs.Ever since I retired in July 2014 the interest rates on FDs ( where I have parked my PF money ) has gradually decreased. Even being a central PSU employee I get a paltry pension which is nothing but 6.5 % interest on deductions made from my salary from 2003 (when pension was introduced ) till my retirement.This money was invested by my employer in LIC pension scheme and LIC gives 6.5 % interest on it and dividing it by twelve sends that amount in my bank account on 1st of every month.Before last budget I wrote to Finance Minister requesting him to atleast keep the interest rate on such deposits ( verified against retirement papers ) fixed so that in old age one does not have to face shrinking income.I also pointed out that those retiring from central government departments get a handsome pension which ( more importantly ) gets revised periodically.Then why this step motherly behaviour with CPSU employees ? The mail sent to Union FM 's mail address obtained from Ministry's website bounced ! Then I repeated it to Revenue Secretary requesting him to forward it to FM.True to our work culture there was no acknowledgement but atleast the mail did not bounce.

Like (1)

evaman

Dec 16, 2016

If low interest rates could lead to higher economic growth, why has US and Japan been struggling and US market cheering when the rates were hiked.
The real problem with the banks are their NPAs which no one is wanting to address. A large portion of the corruption and black money may well be hidden behind these NPA.

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Amish

Dec 16, 2016

Very good article, as usual. But wouldn't it be more complicating for the banks given that due to current slowdown, the possibility of rise in NPA provisioning by banks can't be ruled out. Hence, to protect their margins and operate as profit making entities, would it be viable for banks to provide cheaper loans ?

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